Retirement in Sight? Balance Your Risk Tolerance, Need for Growth

Dear New Frugal You, I am a very frugal person and, if possible, I want to save in any way I can. I have $77,000 in my 401(k) and can roll it over to an IRA. Do you think I can save more on this considering the up and down in stocks? Thanks for your advice.

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-Don

Dear Don,

If I understand your question right, what you ask raises a very important point for anyone saving for their retirement.

Until the current recession, most people trusted that appreciation in their homes and a growing retirement account (IRA, 401(k), etc.) would help to provide for their senior years. With many homes and retirement accounts losing 25% or more of their value, that assumption is being tested. Many are asking the same question as you: How do I protect my retirement savings from declining?

The first thing you'll want to check is what investments are allowed in your specific IRA and 401(k) plans. You might be surprised at what you'll find.

As a practical matter, the IRA trustee or administrator may limit your options. Banks especially like you to choose CDs and may force that choice by not offering any stocks or mutual funds. If you choose a brokerage or mutual fund firm, you'll have those choices available to you.

Similar rules apply to your 401(k) plan. The law allows for a variety of investments. Again, the plan administrator is the one who limits your options.

You might consider your 401(k) plan to be a "stock plan" because your employer uses its company stock for any matching contributions. But, typically, once those shares are vested, you are free to sell them and reinvest the proceeds in something different.

Check with your plan administrator to see what's permitted in your account. You may find that you can choose CDs or other investments where your principal is guaranteed or insured.

But before you make any changes, you might want to reconsider your investment objectives. Your first consideration should be your investment horizon. Or, translated to English, for how long are you investing.

According to the United States Centers for Disease Control, your life expectancy is nearly 80. So, barring known medical issues, you need to invest with an eye over the next 20-plus years. (Let's hope that you live well past 80 and pull the average up! But, that means an even longer investment horizon.)

Having your principal guaranteed is nice. It is especially attractive after you've watched your stocks take a beating.

But you also need to consider what that principal will buy. Over 20 years, even a 3.5% inflation rate will cause prices to double. So expect that today's $2 loaf of bread will cost $4 in 20 years.

For the vast majority of us, that means that we'll need to have some growth in principal. And, typically, that means investing part of your account in stocks, stock-based mutual funds or inflation hedges (such as gold, silver, oil, real estate).

As you'd expect, some shorter periods are tougher than others for stocks. For instance, from 2001 to 2010, stocks returned an average of 1.4% compared to 2.2% for Treasury bills. But stocks will outperform over a longer time frame.

Should you put all of your money in stocks? Of course not! But putting everything into CDs or something similar isn't advisable either. You need a balance in your retirement plan. A little research on "portfolio allocation models" will help you determine the appropriate balance. Choose a model that matches your situation and willingness to take risks.

It's hard not to get discouraged when the stock market is impersonating a roller coaster, and the housing market has collapsed. But remember that your retirement account needs to protect your ability to buy necessities for quite a few years. So even after you retire, you will still need some growth in your investments. Unless you die young, putting all of your funds into CDs and other guaranteed investments could really be a guarantee that you'll lose purchasing power in the future.